The company filed suit on May 5, the day before it emerged from 15 months of bankruptcy protection (and amended its complaint on Oct. 10, 2003). The suit asked the bankruptcy court in Chicago to step in, under 11 U.S.C. §505, to lower the company's 2001 and 2002 tax assessments on inventory, property and other goods by some $8.6 million. The complaint alleged that "the allocation formula adopted by the defendants in arriving at the assessments is arbitrary, imprecise and unreasonable" and concluded that it "constitutes no proper basis for the valuation of the property."

About 150 municipalities and taxing authorities settled.¹ Those communities that failed to settle urged the court to dismiss for failure to state a federal cause of action, and in any event, that the company waited too long to object or failed to detail why their assessments were flawed. On April 19 of this year, Bankruptcy Judge Jack Schmetterer (N.D. Ill.) dismissed Kmart's case, without prejudice, for failure to plead jurisdiction to keep the case in federal court. The dismissal avoids, for now, a federal ruling on an important, recurring valuation controversy—namely, how to assess the value of a company's inventory and other goods for business tax purposes when that company is operating under bankruptcy protection.

Most local governments use a simple method that's been around for decades, based on the purchase price less depreciation from a tax table. Kmart sought to use a more complex formula—taking into account market conditions and the financial state of the company—that produces a lower value. These tax disputes often occur when the economy or a company runs into trouble; when companies are making healthy profits, they don't usually quibble about property taxes.²

Notwithstanding the outcome here, the property tax savings that may be available to a typical chapter 11 debtor are sizable, adding significant value back to the estate. This is particularly true where the debtor's operations are located in a single jurisdiction, rather than Kmart's hundreds of locations. Tax consultants such as those retained by Kmart may be profitably retained to quantify the benefit of the estate. This article will discuss the methods for determining true value in the context of the Kmart litigation.

Kmart's Prayer for Relief

State constitutions and tax codes of the various states require that assessed values for imposition of ad valorem taxes be made on the basis of the "fair market value" (FMV) of the property, expressed in either those terms or specific state terminology of substantially equivalent meaning. While the terminology may vary slightly from state to state, the principle of valuation on the basis of what is recognized in established appraisal doctrine is a constant. Illustrative is the definition of FMV in the California Revenue and Tax Code, §110(a):
the amount of cash or its equivalent that property would bring if exposed for sale in the open market under conditions in which neither buyer nor seller could take advantage of the exigencies of the other, and both the buyer and the seller have knowledge of all the uses and purposes to which the property is adapted and for which it is capable of being used, and of the enforceable restrictions upon those uses and purposes.

Each of the states (25 in the Kmart case) where the relevant jurisdictions were located has incorporated in its system of statutory and case law a closely or approximately equivalent substantive definition of FMV, the standard by which appraisals and/or assessments must be made for all ad valorem property taxes. Some local assessing jurisdictions may adopt typical methodologies for arriving at their initial market value estimates, but once a particular valuation has been called into question, the underlying state statutory standard requires valuation consistent with the ultimate legal standard of FMV.

Kmart sought neither imposition of monetary damages, injunctive or contempt relief, but merely a determination, pursuant to the court's power under §505, that the defendants imposed ad valorem taxes based on values far in excess of the appropriate market values.

The Argument Against

The non-settling taxing authorities urged the bankruptcy court to abstain from a re-determination of value for state and local tax purposes, and to dismiss. By its plain language, the Code does not require the court to re-determine state and local tax liability. Under §505(a)(1), the court has "purely discretionary" authority to re-determine a debtor's tax liability. In re Metromedia Fiber Network Inc., 299 B.R. 251, 280, fn 24 (S.D.N.Y. 2003). See also, In re Galvano, 116 B.R. 367, 372 (E.D.N.Y. 1990) (the court's authority to determine a debtor's tax liability is discretionary); Williams v. Internal Revenue Service, 190 B.R. 225, 227 (W.D. Pa. 1995) (the court is not required to determine the amount of the tax).

Moreover, §505(a)(2)(B) provides that the court may not consider any right of the estate to a tax refund until the earlier of 120 days after the trustee "properly requests" such refund or the governmental unit makes a determination on such request. In re Continental Airlines, 149 B.R. 76, 84-85 (D. Del. 1993). The debtor here made no claim to have complied with the jurisdictional requirement of requesting a refund. Various state laws also narrowly proscribe the circumstances for requesting a refund, and such laws are entitled to credit by the bankruptcy court. When failure to timely request a refund or file a tax appeal results in a bar to a refund under applicable non-bankruptcy law, §505(a)(2)(B) prohibits a court from adjudicating the request for a refund. In re Constable Terminal Corp., 22 B.R. 734, 739 (Bankr. D. N.J. 1998), aff'd., 246 B.R. 181 (D. N.J. 2000).

Other courts have likewise construed the term "properly request." In In re St. John's Nursing Home Inc., 154 B.R. 117 (Bankr. D. Mass. 1993), aff'd., 169 B.R. 795 (D. Mass. 1994), the bankruptcy court analyzed Massachusetts' statutory scheme for obtaining a tax refund and declared that a taxpayer cannot properly obtain a refund of an overpayment of taxes from a bankruptcy court without first filing an application under state law. In this case, the chapter 11 trustee sought reassessment of the value of the debtor's nursing home and a refund of property taxes paid. The bankruptcy court abstained from adjudicating the tax refund request, citing public policy and the plain meaning of §505.

If the court were to undertake a re-determination, it would have to interpret and apply the property tax laws of every other jurisdiction involved—in this case, hundreds of different laws. This presents several problems. Not only would the court have to review and analyze the property tax laws of multiple jurisdictions, but also conduct individual evidentiary hearings on the complex and unfamiliar laws of each jurisdiction. This would clearly burden the court. Many courts have abstained under similar circumstances. In re Metromedia Fiber Network Inc., 299 B.R. 251, 283-84 (Bankr. S.D.N.Y. 2003); In re Cody, 281 B.R. 182, 194 (S.D.N.Y. 2002); In re Building Technologies Corp., 167 B.R. 853, 859 (Bankr. S.D. Ohio 1994). Other objections centered on the lateness of the appeal by the debtor, the failure to follow state procedures in place to handle appeals of tax determinations and the substantial impact on state revenues.³

Tax Commissioner Overruled Based on "True Value"

Complainants can win these cases—with the right facts and a compelling appraisal report. Illustrative is a 2001 case from Missouri, Solar Press Inc. v. White, Assessor of Perry County. Here, the complainant's appraiser valued about 1,400 items of property, relying on comparative sales data and a discounted cost analysis or replacement cost, less depreciation. The value was based on the concept of FMV—the estimated amount in terms of money that may reasonably be expected for an item of property between a willing buyer and willing seller with neither under compulsion to buy or sell and both fully aware of all the relevant facts. The hearing officer found that personal property is valued based on its true value in money and value in exchange, not value in use or value installed. The complainant appraiser relied on a comprehensive database of asking and selling prices, auction sales and any other type of transaction available. This sales data "establishes the prices at which the various individual items of property are selling in the market. From such data, a clear indication of the value for the various pieces of machinery, tools and equipment can be developed." Decision at p. 12.

The fact that some sales, or even a large number of sales, are auction sales, orderly liquidation or forced liquidation, does not render such sales invalid for developing an opinion of value. This market arena, with its mixed information base, is where real transactions occur each day and is therefore valid to use as a comparable sale for a like piece of machinery.

In contrast, the respondent taxing authority's expert was found not persuasive, with a number of the values determined by estimate, or without making appropriate adjustments or in reliance on outdated depreciation tables. The case confirms the important role played by competent valuation professionals.

Footnotes

¹ Merrick, "In Kmart's Leftover Bin: Nasty Tax Scrape with Towns," Wall Street Journal, March 31, 2004, page A1. Return to article

² Walsh, "Kmart Dispute Shows Tax Code Is a Quagmire," Detroit Free Press, April 2, 2004. Return to article

³ "The 2001 tax dollars paid by Kmart to [Florida] were distributed to the taxing authorities and used to pay teachers, firemen, police and other governmental services used by Kmart in the operation of their stores...the time within which Kmart can contest the 2001 taxes has long since expired." Florida Tax Collectors' Motion to Abstain Regarding First Amended Adversary Complaint for Determination of Tax Liability Pursuant to 11 U.S.C. §505, filed Jan. 20, 2004. Return to article